Heating, ventilation, air-conditioning, and refrigeration (HVACR) distribution equipment and parts company Watsco (WSO -1.53%) has a fantastic track record of delivering returns for investors. Not only has the share price delivered stellar returns, but the dividend has grown by a compound annual growth rate of 21% since 1989. However, where a company is going matters more than where it came from, so is Watsco still a good investment? Here's the lowdown. 

Watsco's difficult year

It's a legitimate question, particularly as a quick look at Watsco's headline fundamentals and Wall Street analyst estimates for 2023 suggests the company is passing through some challenging conditions. For example, sales over the last nine months came in flat over the same period last year, and declined 1% on a same-store basis, the company said in its third-quarter report.

Moreover, Wall Street analysts expect just 0.6% sales growth overall in 2023. It's a similar story with earnings per share (EPS), with nine-month EPS coming in at $11.60 compared to $11.86 over the same period last year, and analysts expecting full-year EPS to decline to $13.98 compared to $15.41 in 2022. 

What happened to Watsco in 2023?

While the performance this year is superficially disappointing, it needs to be viewed in the context of a few factors that indicate Watsco will return to growth sooner rather than later:

  • This year, the industry underwent a huge product transition due to minimum efficiency standards mandated in the U.S.
  • Watsco's comparables with previous years are made difficult due to the lingering impact of the pandemic.
  • The slowdown in the economy this year has impacted end demand.

The product transition issue is highly significant and was highlighted by founder and CEO Albert Nahmad on the second-quarter earnings call in August when he noted, "Approximately 60% of the equipment we are selling today represents new or revamped products."

An investor in front of a buy and sell signal.

Image source: Getty Images.

Such transitions are fraught with difficulty in the best of times, but throw in the added complication of the supply chain and material product availability issues that hit the industrial economy after the pandemic lockdowns, and it's a recipe for significant disruption. Indeed, one of Watsco's original equipment manufacturer (OEM) partners struggled with product availability issues this year, which hit Watsco. Nahmad estimated a $125 million sales impact for the first half alone, and to date, Watsco has added 400,000 new stock-keeping units since the start of the year. 

Turning to the issues of more challenging comparables created by the distortive impact of the pandemic and slowdown in the economy, that can be seen in the following chart of nine-month sales compared to previous years. 

As you can see below, Watsco's sales rose 22.3% in 2021 and 19.3% in 2022 -- 17% on a same-store sales basis for both years. These growth rates are not sustainable over the long term.

Still, it's worth noting that even the flat sales performance in the first nine months of 2023 still leads to a compound average growth rate (CAGR) of 11.3% since 2019. 

Watsco sales chart.

Data source: Watsco presentations. 

Watsco's growth prospects 

Moreover, it's also essential to put it all in the context of Watsco's business "buy and build" business philosophy. The "buy" bit is how Watsco expands geographically and consolidates a highly fragmented end market by acquiring smaller distributors. Meanwhile, the "build" bit refers to improving the acquired distributors by adding products and technologies, including Watsco's digital capabilities such as e-commerce websites, mobile apps, and digitized product information that enable contractors to order HVACR parts and replacement equipment from Watsco easily. 

It's a highly successful strategy that's enabled Watsco to be the clear leader in a highly fragmented field. In addition, the company's rock-solid balance sheet (Watsco is set to end the year with almost $200 million in net cash) means it's ideally placed to pursue add-on acquisitions in a time of relatively high interest rates and uncertainty. 

All told the need to repair and replace HVACR equipment ensures ongoing demand for Watsco's solutions. There's no reason why the company can't continue its highly successful "buy and build" strategy for many years.